August 24, 2015
Forget the Sept. ’15 Fed Tightening –
There Has Been a Stealth Tightening Since Sept. ’14!
The late, great Milton Friedman used to preach that you
don’t assess the degree of monetary policy restriction or accommodation by the
level and movement of interest rates but rather by the behavior of monetary quantities. For Friedman, the monetary
quantity by which he judged the stance of monetary policy was some definition
of the money supply – currency and some of the deposit liabilities of the
banking system. Meaning no disrespect to the greatest monetary theorist of the
20th century, but the monetary quantity I prefer to use to measure
the stance of monetary policy is on the asset side of the banking system’s
balance sheet -- the sum of banks’ cash
reserves provided by the central bank and
the loans and securities granted by the banking system. By my measure, the
Fed has been gradually tightening its monetary policy at least since September 2014. Moreover, in recent months, Fed monetary policy has become
downright restrictive.
This is illustrated in Chart 1. Plotted in Chart 1 is the
behavior of the sum of commercial bank credit – loans and securities held by
U.S. commercial banks -- and the cash assets held by these commercial banks –
largely banks’ cash reserves created by the Fed. Past readers of my
commentaries will recognize this monetary quantity as my concept (really
Austrian economists’ concept) of “thin-air credit”. I refer to it as thin-air
credit because cash reserves provided by the Fed are created, figuratively, out
of thin air and so, too, is commercial bank credit in the fractional-reserve
banking system that we have in the U.S. The red bars in Chart 1 represent the
month vs. year-ago month percent changes in this monetary quantity. The blue
line represents the three-month annualized percent changes in this monetary
quantity. To put things in an historical context, the median percent change in
the annual averages of this monetary quantity from 1975 through 2015 was 6.62%.
Chart 1
The year-over-year percent change in the sum of
commercial bank credit and cash assets peaked in July 2014 at 9.74% (the red
bar just to the left of the solid black vertical line in Chart 1). The Fed’s
third round of quantitative easing (QE), which had begun in September 2012 and
was terminated in October 2014, was still being phased down in July 2014. The
year-over-year percent change in this measure of thin-air credit has trended
lower since July 2014, slowing to only 4.45% as of July 2015. The more variable
three-month annualized growth in this measure of thin-air credit also has been
trending lower since July 2014, slowing to 1.25% as of July 2015. Against the
backdrop of a 40-year median growth rate of 6.62% for this measure of thin-air
credit, recent months’ growth rates in it are relatively low, implying that the Fed’s monetary policy has
gone from accommodative in July 2014 to
restrictive in July 2015.
Plotted in Chart 2 are the year-over-year percent changes
in the two components of this measure of thin-air credit – the cash assets held
by commercial banks, primarily cash reserves provided by the Fed, and loans and
securities held by commercial banks. This chart shows that key driver of the
slowdown in thin-air credit growth since July 2014 has been the slowing in cash
assets held by commercial banks, i.e., a slowdown in the Fed’s provision of
bank reserves. In each of the three months ended July 2015, commercial bank
cash assets have contracted vs. year
ago. Although commercial bank credit growth has slowed in recent months, it
nevertheless remained relatively robust in July 2015 at nearly 7% on a
year-over-year basis.
Chart 2
It stands to reason that growth in bank reserves would
slow as the Fed tapered and then ended its purchases of securities, the largest
source of reserve creation. But ending Fed securities purchases would not
necessarily result in a contraction
in bank reserves. But as Chart 3 shows, this is exactly what occurred. While
the year-over-year dollar change in Fed securities holdings has narrowed, the
year-over-year dollar change in bank reserves has actually contracted in six of
the past nine months.
Chart 3
Chart 4 shows that as the year-over-year dollar changes
in in the total supply of reserves, Fed security holdings plus other factors such
as Federal Reserve float, have become smaller since the Fed began phasing out
QE3, the year-over-year dollar changes in factors other than bank reserves absorbing the supply of bank reserves have
increased. Some of these absorbing factors such as currency demanded by the
public and Treasury deposits held at the Fed are beyond the Fed’s control. Back
in the pre-QE era, the Fed used to engage in what were termed “defensive” open
market operations to offset undesired absorption of reserves from these
uncontrollable factors.
Chart 4
But as shown in Chart 5, there have been some factors
absorbing the supply of reserves under
the Fed’s control that have been increasing. These two reserve-absorbing
factors controlled by the Fed are reverse repurchase agreements with government
securities dealers and money funds and term deposits offered to commercial
banks and other depository institutions. For reasons known only to it, the Fed
began “experimenting” with these reserve-absorbing operations early in 2014 as
it began tapering its reserve-supplying securities purchases. The Fed then
stepped up its reserve-absorbing operations from October 2014 through February
2015, after it had ceased its QE
securities purchases. Go figure.
Chart 5
The upshot of all this is that from a monetary quantity perspective, monetary policy
has tightened significantly from a year ago. Growth in the credit being created
by the private banking system has returned to near its long-run median rate
after having been severely constrained during and after the 2008 financial
crisis. But total thin-air credit
growth is below its long-run median rate because of the slow growth or
contraction in the Fed’s contribution. In my opinion, the Fed was correct in
phasing down its securities purchases when it commenced to do so. Growth in
total thin-air credit was excessive at that time. But without the Fed having
any clear understanding of how many securities to purchase when it commenced
its three QE programs, it had no idea of by how much it should taper its
securities purchases. The Fed’s management of securities purchases and reserves
growth needs to be guided by what was happening to growth in total thin-air credit – banks’
contribution and the Fed’s. There is
absolutely no evidence that the Fed has been guided by this. As a result,
monetary policy has gone from one extreme – overly accommodative – to the other
– overly restrictive. The more things change, the more they stay the same.
Now, let’s talk about something important – the recent
swoon in the U.S. stock market. Plotted
in Chart 6 are the year-over-year percent changes in monthly observations of
the Wilshire 5000 stock market along with year-over-year percent changes in
monthly observations of thin-air credit. Although growth in the Wilshire 5000
peaked about six months before
thin-air credit growth peaked, the peak in the Wilshire 5000 growth occurred
around the time the Fed began tapering its securities purchases. To the degree
that financial markets anticipate
events, it is conceivable that the stock market movers and shakers anticipated
that the Fed’s phasing out of its securities purchases would eventually have an
adverse effect on stock market values.
Chart 6
After massive purchases of securities by the Fed, why
might the cessation of these purchases have an adverse effect on stock market
values? When the Fed purchases securities, the sellers are government
securities dealers. Dealers do not hold the quantities of securities that the
Fed was purchasing during QE, especially after the 2008 financial crisis. In
order to accommodate the Fed’s demand for securities, dealers bid for
securities that their customers held. Dealers’ customers are large
institutions, e.g., pension funds, insurance companies, mutual funds, and
banks. The dealer community was an intermediary between the Fed and large
financial institutions. So, when the Fed purchased securities, ultimately,
large financial institutions sold securities and received cash. It is unlikely
that these large financial institutions were to content to give up an earning asset
for cash that has no explicit nominal return. Rather, these large financial
institutions used the cash it received indirectly from the Fed, cash created
figuratively out of thin air, to purchase other earning financial assets. Some
of these assets purchased by large financial assets might have been equities.
Some of these assets might have been bonds issued by corporations for the
express purpose of financing their share buybacks. The Fed’s creation of
thin-air credit likely financed, directly or indirectly, increased purchases of
riskier financial assets, which, in turn, boosted the prices of these riskier
assets. If so, then the Fed’s cessation of securities purchases and contraction
in its contribution to thin-air credit would reduce the demand for riskier
assets, which would have an adverse effect on their prices. So, why did I wait
until now, after the recent swoon in the stock market, to tell you that the
Fed’s cessation of QE would have an adverse effect on the stock market? Well,
truth be told, I did alert you to this probability back on November 17, 2014,
in a commentary entitled “2015 Is
Shaping Up to Be a ‘Turkey’ of a Year for the U.S. Economy and Stock Market”.
But the truth also be told, I had no idea that a stock
market swoon would occur in August 2015. In fact, I had no idea a stock market
swoon would occur at any time in 2015. But it did appear to me back in November
2014 that thin-air credit growth was likely to decelerate sharply in 2015
compared to 2014. And that a sharp deceleration in thin-air credit growth would
have adverse effects on nominal aggregate demand and the value of risk assets.
The adverse effect on the value of risk assets appears to be upon us. Of
course, the collapse of the Chinese stock market has played a large role in the
decline in prices of U.S. risk assets, perhaps a larger role than the sharp
deceleration in U.S. thin-air credit. Weather-adjusted, U.S. aggregate demand
has held up relatively well. I suspect that will change in the fourth quarter
of this year.
In the face of very low goods/services price inflation
and weak wage growth, the recent U.S. stock market rout is likely to postpone
the previously-anticipated September 2015 Fed rate hike. It is too early to
expect QE4. But the Fed certainly has the leeway to restart securities
purchases if need be. In other words, take some comfort in a Yellen put.
Paul L. Kasriel
Econtrarian, LLC
Senior Economic and Investment Advisor
Legacy Private Trust Co. of Neenah, WI
1-920-818-0236
